The large losses suffered by private and government mortgage
insurers during the last several year has renewed in identifying the
risk factors associated with residential lending. This paper focuses on
the effect of state foreclosure laws on that risk. Data on loss rates
incurred by PMIs over the period 1980-1986 reveal that a judicial
foreclosure requirement and a statutory right of redemption add
significantly to mortgage risk. Anti-deficiency judgment statutes
preclude the amelioration of such risk. Estimates of the losses due to
such laws are included

Introduction

One result of the mid-localized recessions in the agricultural and
oil sectors of the economy has been an increase in residential loan
defaults and foreciosures. Both government (FHA and VA) and private
mortgage insurance (PMI) company claims have risen sharply since the
early 1980s. (1) In 1986 the combined ratio of the loss and expense
ratios for all PMI's was a record 168.9 percent. By comparison,
the ratio was only 55 percent in 1979. Direct losses paid as a percent
of the previous year's risk in force were .17 percent for 1980 and
1.35 percent for 1986. By 1986 the weighted average risk-to-capital
ratio for the industry reached a record 25.8:1, several companies
required capital infusions from their parent companies, and others had
their ratings reduced by the rating agencies. (2)

Besides localized recessions, other frequently noted risk factors
have been mentioned as deepening the financial difficulties of the PMI
industry. They include the introduction of new loan types (negatively
amortizing Arms and GPMs), an increase in insured investor (non-owner
occupied) properties, and a greater proportion of over-90 percent
loan-to-value ratio loans originated by lenders.

The consensus appears to be that the PMI industry failed both to
adequately underwrite the risks associated with the characteristics of
loans they insured and to charge premiums which reflected those risks.
Throughout the early and mid-1980s, PMI companies charged uniform
premiums regardless of the loan's characteristics, including
location of origination. (3) It should not be surprising that in the
fact of uniform premiums, differential amounts of risk were shifted to
the insurers.

Among the risks that may have been differentially shifted, there is
one that has received little attention in the literature. That is the
risk associated with the legal structure of the default-foreclosure
process of the state within which the mortgaged property is located.
This structure varies dramatically. The laws in some states facilitate
the foreclosure process and thereby ameliorate lender-insurer losses.
The laws in others, in an attempt to provide greater protection to the
mortgagor, cause the process to be more lengthy and costly.

This study demonstrates the extent to which different foreclosure
laws create loan risk differentials which have been refelected in the
losses of private mortgage insurers. The period of the interest is 1980
through 1986. (4)

The manner in which state foreclosure laws affect residential loan
risk is briefly discussed. A model is then presented wherein this risk
is shifted disproportionately to private mortgage insurers that charge
uniform premiums. Empirical evidence then shows that such risk caused
substantial losses for PMI's from 1980 through 1986. Findings are
then summarized and suggestions for future research are offered.

State Foreclosure Laws and Loan Losses (5)

Aside from minor differences, there are three primary distinctions
in state foreclosure laws. They all affect the size of residential loan
losses. First, states are almost equally divided between those that
employ a judicial foreclosure procedure and those that employ a
power-of-sale procedure. (6) In a property procedure a court orders a
foreclosure and supervises the sale of the property and the disbursement of the proceeds. Because they are more time consuming and necessitate
the use of legal professionals, judicial procedures are more costly.
Time consuming methods of foreclosure impose greater costs on lenders
(foregone interest and real estate owned, REO, expenses such as hazard
insurance, property taxes, maintenance, and so forth). A non-judicial
procedure allows the foreclosure to be conducted expeditiously without a
court proceeding, often through a trustee's sale.

Second, the laws in 29 states provide for a statutory right of
redemption: a period of time subsequent to foreclosure (which varies by
state with one year being the norm) during which the mortgagor can
redeem the property by paying delinquent interest, penalties, and legal
costs. (7) This provision can be particularly costly to lenders if the
owner is granted the additional right to occupy the property during this
time. The existence of the statutory right of redemption has the
additional effect of reducing the interest of potential buyers of the
property at a foreclosure sale, lowering the liquidation price that the
lender would otherwise receive.

Third, although most states allows for deficiency judgments, six
states (including California) do not. A deficiency judgemtn arises when
the proceeds from the foreclosure sale are insufficient to satisfy the
loan balance (which is usually the case). Equipped with a deficiently
judgment, a lener (insurer) can proceed to recover directly against the
mortgagor's personal assets. In some cases the cost of pursuing
the judgment, combined with the paucity of personal assets of the
mortgagor, may discourage the implementation of the judgment. As a
results, deficiency judgments may not be pursued in every case where
they are allowed. However, for some cases the threat of a judgment will
often suggest a settlement. The lender, in order to avoid the cost of
litigation and the borrower, to avoid a bad credit rating, may agree on
a partial payment of the deficiency. Therefore, in those states where
its use is universally prohibited, lender losses will be, ceteris
paribus, greater. (8)

In summary, because a judicial procedure and a statutory right of
redemption lengthen the foreclosure process and delay the liquidation of
the property, losses are greater in states which require the former and
grant the latter. A prohibition on deficiency judgments precludes any
amelioration of these losses.

Some Initial Evidence

A study commissioned by the Federal Home Bank Board (FHLLB) (1975)
confirmed the notion that state laws which retard the foreclosure
process impose greater losses on lenders. The study examined the losses
on 30 foreclosed loans of each of two thrifts in Illinois and two in
Texas. At the time of the study, Illinois had a judicial procedure and
a one-year statutory right of redemption. Texas employed a non-judicial
procedure and granted no statutory right of redemption. In addition to
the unpaid balance, the lenders' exposure on the loans included:
foregone interest, attorneys' fees, court costs, property taxes,
repairs, hazard insurance, and indirect costs. When the liquidation
value of the property and rental revenue were deducted from these costs,
the average loss in Illinois was 53 percent of the average loan balance.
In Texas it was only 6 percent. Though the study was based on a
relatively small sample, it nonetheless concluded that there was strong
evidence that the magnitude of the financial impact of foreclosure is a
function of state foreclosure law.

Private Mortgage Insurance and Risk Shifting

The typical mortgage insurance contract provides for the full
payment of losses up to a minimum percent of the exposure. (9) For
losses greater than the minimum percent, the contract takes on a
coinsurance character. The loss is generally the exposure less the
liquidation value of the property. The exposure is defined as:

A = attorneys' fees (limited to 3 percent of the unpaid balance
plus forgone interest), and

R = rental revenue.

It is clear from the elements in equation (1) that the retardation
of the liquidation process by arduous foreclosure proceedings increases
the exposure.

Now the insurance indemnity is:

I = Min[E-H,[alpha]E] where H is the liquidation value of the houes
and [alpha] is the co-insurance percentage. An increase in E via
arduous foreclosure laws raises I. If the exposure is small such that
the insurance payoff is E -- H, all of the lender's losses are
covered. The lender may have little or no incentive to minimize the
exposure. (10) However, if the exposure becomes greater, the
coinsurance feature of the contract is more likely to be engaged, i.e. E
-- H[is greater than][alpha]E. Since the lender bears some of these
costs, it has an incentive to minimize them. it may be more likely to
pursue or, in expectation of a settlement, threaten to pursue, a
deficiency judgment. the result is that claims paid by private mortgage
insurers, I, will be greater states require a judicial procedure,
provide for a statutory right of redemption, and prohibit deficiency
judgments.

Model and Empirical Results

In order to isolate the effect of state foreclosure laws on PMI
losses, one must consider the remaining variables that can reasonably be
expected to affect those losses. The following set of variables is
proposed.

Residential Property Prices (Equity)

Studies by von Furstenberg (1969, 1970, 1974) have demonstrated an
inverse relationship between the amount of equity in a property (as
measured by the complement of the loan-to-value ratio) and the
likelihood of default. The so-called equity theory holds that it is
irrational for a mortgagor to default on a loan when there is positive
equity in the property. States with appreciating property prices should
experience fewer defaults and foreclosures than those with stagnant or
declining values.

Ability-to-pay (Unemployment and Divorce Rates)

In contrast, the ability-to-pay theory suggests that defaults
result from events such as involuntary unemployment and divorce which
affect the ability or motivation of the borrower to meet the monthly
payment. Theory would suggest, however, that there should be no default
in the presence of such events if there is positive equity in the
property. On the other hand, one could argue if one of the above events
causes the borrower to fail to make payments for several months any
positive equity may be eroded to the point where default becomes an
optimal decision. In a test of the ability-to-pay and the equity
theories, Jackson and Kaserman (1980) concluded that the equity theory
is superior. However, Campbell and Dietrich (1983) found a statistical
relationship between regional enemployment and default rates, and Foster
and Van Order (1984) indicate marginal support for the effect of divorce
rates on defaults. For completeness these variables are included.

Market Interest Rates

The relationship between the current market rate of interest and
the loan's contract rate can affect the likelihood of default and
foreclosure. The effect is not unambiguous, however. Mulherin and
Muller (1987) suggest that if the market rate is substantially above the
contract rate on the delinquent loan, the lender has an incentive to
foreclose (rather than seek a non-forclosure alternative such as a
forbearance) because it is able to lend the proceeds of the foreclosure,
including insurance payments, at the higher market rate. Clauretie
(1987) found support for this hypothesis in a model of foreclosure
behavior. On the other hand, mortgagors have an incentive to make an
effort to preserve the low-rate loan. In the situation where the market
rate is above the contract rate, mortgagors have less incentive to
default. The effect of changing market rates is an empirical one.

Time Lags

Studies by United States agencies (1962, 1963, 1966) indicate that
defaults on residential properties peak between two and six years
subsequent to origination. The available data set on mortgage
insurer's losses is aggregate and does not include the date of
origination of individual loans. The current study allows the property
price appreciation and interest rate variables to take on a lag between
two and six years. That lag is selected for which the t-value of the
coefficient is the largest. It is expected that voluntary unemployment
anddivorce would affect the likelihood of default within a year or so.
These variables are entered with shorter lags.

[L.sub.j,t] = the log of the loss rate for all PMI's in state j
in period t, (11)

[P.sub.j,t _ x] = the percent change in residential property prices
in state j from period t - x to period t: x is allowed to range from two
through six,

[R.sub.t - x] = the level of market mortgage rates (national) in
period t relative to period t - x: x is allowed to range from two
through six: entered as [r.sub.t. - r.sub.t - x][/r.sub.t - x]

[[Delta]U.sub.j,t - x] = change in the unemployment rate in state j
in period t - x: x varies from one to two years,

[D.sub.j,t - x] = divorce rate in state j in period t - x: x varies
from one to two years,

[PS.sub.j] = dummy variable equal to one if a state has a
power-of-sale foreclosure process and zero otherwise,

[SRR.sub.j] = dummy variable equal to one if a state has a statutory
right of redemption and zero otherwise (alternatively, the length of the
statutory right of redemption is included),

[DJ.sub.j] = dummy variable equal to one if a state prohibits a
deficiency judgment and zero if otherwise, and

[[epsilon].sub.t] = error term.

The signs on [beta.sub.1] and [beta.sub.5] are expected to be
positive while those on [beta.sub.4], [beta.sub.6], and [beta.sub.7] are
expected to be negative.

The model is tested using annual data for the dependent variable
for 51 jurisdictions from 1980 through 1986 (357 observations). Data
for the explanatory variables are described in the appendix.

Empirical Results

Equation 3 was tested employing, alternatively, a dummy variable
for the presence of a statutory right of redemption and the length of
the statutory right to redemption (in months) as one of the three legal
variables of interest. The results are displayed in Table 1.

With the exception of the incorrect sign on the unemployment
variable, the explanatory variables behaved as hypothesized. The
important non-legal variable is the measure of property price
appreciation. This result supports the equity theory of default. The
legal variables appear important in explaining insurers' losses
over this period. Given that the average length of a statutory right of
redemption where it exists is ten to 12 months, the coefficients on the
alternative forms of this variable are consistent. Loan losses are also
less where lenders can pursue a deficiency judgment or employ a
power-of-sale foreclosure.

Estimate of losses imposed on lenders by variations in the legal
structure of the foreclosure process can be made from these results.
The effect of the various legal distinctions on the log of the loan loss
rate (at the mean) and, in turn, the loan loss rate can be determined
from the coefficients included in Table 1. These effects are summarized
in Table 2. Given the amount of risk-in force for private mortgage
insurers, loss rates imply certain dollar losses.

During the period of analysis, private mortgage insurers had a
total risk in force that averaged approximately $40 billion. In 1986
approximately 30 percent of insurer's risk-in-force was allocated
to states with a statutory right of redemption. (12) Furthermore, the
existence of this redemption period adds approximately 21 basis points
to insurers' loss rates. With an assumed $40 billion national risk
exposure, insurers' losses can be estimated to be $25 million
annually as a result of this provision ($40 billion X .3 X .0021).

Similarly, 44 percent of the national risk-in-force has been
allocated to states which employ a judicial foreclosure. Losses as a
result of this provision are estimated at $26 million annually ($40
billion X .44 X .001463).

Finally, the prohibition of the use of a deficiency judgment by six
stats that represent 18 percent of the risk-in-force add 36 basis points
to the loss rate or approximately $26 million annually ($40 billion X
.18 X .0036).

Policy Implications

There are a couple of implications of this study. first, since the
foreclosure laws of the state within which the mortgaged property lies
affect the risk of the loan, private mortgage insurers should, and
perhaps will, consider pricing the premium to rflect that risk. If this
becomes a standard practice among mortgage insurers, then decidedly more
of the risk will be shifted bck to the borrowers that pay the premium.
Differential premiums which reflect the legally induced risk will then
lead consumers (borrowers) to reflect on the laws of their state which
may presently favor them by impeding the foreclosure process.

Second, an awareness of the impact on loan losses from differential
foreclosure laws may lead to greater state acceptance of the Uniform
Land Transactions Act. This Act, would cause foreclosure laws to become
more uniform while still affording protection to the borrower. The Act
encourages the use of the non-judicial foreclosure procedures,
eliminates the statutory right of redemption, and makes uniform the use
of a deficiency judgment.

Conclusion

This study demonstrates that the variation in state laws regulating
the foreclosure process causes differential rates of losses on
residential loans. The evidence comes from the loss rate (claims as a
percent of risk-in-force) for private mortgage insurers from 1980
through 1986. Laws which benefit the mortgagor through slowing the
foreclosure process or limiting remedies through deficiency judgments
result in greater losses for insurers and, because of the coinsurance
nature of the contracts, lenders. The three main legal distinctions
discussed likely added approximately $ 75 million annually to private
mortgage insurers' losses over the period.

Future research sshould extend the investigation of this issue by
analyzing loss data from lenders or losses imposed on government
insurance agencies. There may be some structural differences between
PMI and government mortgage insurance. Since the FHA rules for the
administration of home mortgages provide for the termination of a
statutory right of redemption for delinquent loans where a deed-in-lieu
of foreclosure is obtained, FHA losses may be ameliorated. Analysis of
FHA claims should reveal any structural differences.

3. Residential Property Prices: Two data sources: (a) Value of New,
Privately Owned, Single Family Residents by State From Housing Units
Authorized by Building Permits and Public Contract, Annual Issues, U. S.
Dept. of Commerce Bureau of the Census; (b) Monthly Report, Existing
Home Sales, National Association of Realtors, various issues (data here
are on a regional, not a state basis). Entered as percent increase in
period t over t -- x.

4. Unemployment: entered as change in rate of unemployment as
reported by the BLS, various issues and divorce rate entered the rate as
reported in Vital Statistics, various issues.

(1) Losses for private mortgage insurance companies have been
greatest for loans made in states where mineral (including oil and gas)
extraction is a dominant industry. Six states -- Alaska, Texas,
Louisiana, Oklahoma, Colorado, and Wyoming -- accounted for 50.8 percent
of all direct losses incurred in 1986 although they represented only 18
percent of the industry's risk.

(2) The loss ratio is the dollar amount of claims incurred as a
percentage of earned premiums and the expense ratio represents the costs
of obtaining new business as a percentage of premium written. The
combined ratio can be used to indicate the claim-paying ability of an
insurer. The risk-to-capital ratio is the risk-in-force (defined below)
divided by the company's capital. These values are from
Moody's Investors Service (1987).

(3) In a recent issue of Mortgage Banking, two articles suggested
that the era of uniform pricing by PMIs may be passing. Blood (1987)
indicated that PMI losses in the 1980s have caused insurers to
reconsider the manner in which they underwrite loans in the various
states. Kureera (1987) indicated that at least one major company had
begun to rate loans by state and that territorial pricing was the next
logical step.

(4) Although modern PMI (in the post-war era) began in 1957, the
volume written was negligible until 1975. The most dramatic increase
occurred in the early to mid-1980s.

(5) Only a sketch of foreclosure laws is presented here. The
interested reader is referred to Durham (1986) for a more detailed
presentation of the subtle distinctions of state foreclosure laws.

(6) Technically, the judicial procedure is available in all
jurisdictions but is the only method allowed in 23 states. In the
remaining states lenders may use a power-of-sale procedure and, since it
is less costly, generally provide for its use in the mortgage
instrument.

(7) This period of time is termed a statutory right of redemption
because it is created by state statutes. All states provide for an
equitable right of redemption which allows the mortgagor to redeem the
property prior to foreclosure by paying all delinquent costs.

(8) The value to insurers of a deficiency judgment is indicated by
the terms of the typical PMI contract. Generally, a lender's claim
is limited insofar as the amount of attorney's fees that may be
recovered. A larger amount will be paid, however, if required to pursue
a deficiency judgment.

(9) For an example of a typical contract, see Mortgage Insurance
Companies of America (1988).

(10) The lender may, for example, fail to vigorously pursue the
borrower for delinquent payments. Muller and Mulherin (1988)
demonstrate that under these circumstances there is an incentive
conflict. Lenders may fail to collect delinquent payments or make
needed repairs on the property. Their model of incentive conflicts
lends support to the risk shifting behavior of lenders.

(11) The loss is defined to be the total claims divided by the
risk-in-force at the end of the previous year. The risk-in-force is the
product of the loan amount and the coverage ratio. The log of this rate
is taken because the rate is bounded by zero on the downside and is
positively skewed Inspection of the data indicate that the loss rate is
log-normally distributed. A normal distribution of the dependent
variable is required for application of an OLS procedure.

(12) Data for 1986 from Moody's Investors Service (1987).
Data for previous years are unavailable. However, this is no reason to
expect that the proportion of risk-in-force allocated to states with
various legal provisions changed substantially over the period.

[3.] Clauretie, Terrence, 1987, "The Impact of Interstate
Foreclosure Cost Differences and the Value of Mortgages on Default
Rates," Journal of the American Real Estate and Urban Economics
Association, 3: 152-67.